Archive for 2019

Let’s explore several ways to view the last 1+ year of
S&P 500 price behavior through charts.

There are no absolute laws in finance as there are in
physics, chemistry and mathematics; just long-term tendencies arising from
seemingly random short-term price moves, punctuated by infrequent large price
declines followed by gradual recovery. However, some chart patterns
are useful to suggest which tendency is more likely than not to follow
particular recognizable price patterns.

Realize that the movement of stock prices does not reflect
the view of all holders, but rather of the active traders most of the time and
the last traders to act. In the short-term price movements are not based
on fundamentals of valuation, but rather on news flow and sentiment.
There are vast pools of quiet holders who are doing nothing while the price
moves up, down and sideways on the charts. For most investors, most of
the time being part of the quiet money by doing absolutely nothing is the best
course of action.

Visual interpretation of chart patterns (“technical
analysis”) at a minimum has validity in that over time technically oriented
investors have come to expect prices to tend to react to certain chart patterns
in a certain way. Whether the pattern can be traced back to specific
fundamental, macro-economic or sentiment causes becomes somewhat unimportant if
time and time again certain patterns fairly reliably are followed by certain
price behaviors. Technical analysis becomes self-validating as traders in
the aggregate come to believe that chart pattern signals move prices in a
certain way with favorable probability.

For those of us who are not traders, chart analysis can
still be useful by believing in the believers tendency to act, as we decide
things like should I buy that fund or stock today, or wait for the chart
pattern to improve. Accordingly, for those of us who have reserve cash
that we want to put to work in US stocks, the current chart patterns suggest
waiting a bit for the pattern to resolve its trend direction intentions,
although if you have a 5-year to 10-year perspective, the charts might be more
useful as entertainment, the same way you might watch a football game, just to
see who wins.

And by the way, the football analogy for support and
resistance isn’t a bad one. You could think of support and resistance
price levels as analogous to the defensive line players in football, and the
price as the ball carrier, trying for a first down or a breakout run for a
touchdown. When the defensive line (the support or resistance level) is
effective, the ball carrier (the price) is prevented from making headway, and
may actually be pushed back a bit. When the defense is not effective, the
ball carrier (the price) breaks out and moves past the line of defense (the
support or resistance level) until tackled (a short price move past support or
resistance) or finds and open field to run with major yardage gain.

CHART 1:

Chart 1 is a daily chart showing that we have been in
a trading range from 2600 to 2800 for over a year, with a breakout UP and
a breakout DOWN, with a return to the trading range. There have
been more “tops” (shown as red elipses) than “bottoms” (shown as green elipses)
which suggests there may be more in the way of short-term ceiling
(“resistance”) around 2800 than there is a short-term floor (“support”) around
2600.

There is a tendency for prices to bounce down from
resistance and bounce up from support, until the market makes up its mind about
trend direction. Typically, once pierced former resistance becomes new support;
and once pierced former support becomes new resistance – both of these
tendencies failed in this case, as the market was unable to decide to continue
the nascent breakouts. We are in a period of wide range
consolidation. At the end of a long period of consolidation, there is a
tendency for strong directional moves continuing or reversing a former trend.

CHART 2:

Chart 2 is a daily “box chart” to filter out noise in
price movements. The chart does not have a linear timeline, but rather
only plots a new box when the price moves by more than the average move of the
last 14 market days. It simply shows the trading range, tops, bottoms and
breakouts more clearly than the noisy daily Chart 1.

Chart 3:

Chart 3 is a repeat of the daily “box chart” but used
to identify a different pattern, called a “head and shoulders formation”.

Head and shoulders refers to a top followed by a shallow
dip, followed by a significantly higher top, followed by a significant decline,
followed by a lower top; as indicated by the circled areas in the
chart. The line drawn under the bottoms is called the
neckline. When found this pattern tends to be a sign of a major trend
top. If the price after the right shoulder drops below the neckline, it
tends to go as far below the neckline as the head is above the neckline.

We can see that in Chart 3. The price did go below the
neckline, and it did go about as far below the neckline as the head is above,
then it began its strong January recovery; negating the implications of the
apparent head and shoulders.

Chart 4:

Chart 4 is another repeat of the daily “box chart”
with a “Russian Doll” view (a doll within a doll – a pattern within a pattern).
Could it be that the current run-up is merely plotting out the beginning
of the right shoulder of a wider head and shoulders pattern? Don’t know,
but we should find out pretty soon. If it is a larger head and shoulders,
that would be a bad sign. If the breakout continues up to about 2900, then
like the Etch-a-Sketch toy of our childhoods, all the former patterns are
effectively erased from a prediction perspective – then they don’t matter
anymore.

Chart 5:

Chart 5 is a standard daily chart with 7 indicators
plotted upon it, to see if they confirm, disagree with or portend price action.

Moving Average: This chart shows the
200-day average (the thin dashed line in the middle of the green shaded area)
to be nearly flat, slightly up, after a recent dip (not Bearish, not Bullish,
just Neutral)

Standard Deviation: The outer boundaries
of the green shaded area mark a 1 standard deviation distance from the 200-day
average. About 67% of the time you would expect the price to be between
those two boundaries, as it is now – normal. The outer boundaries of the
beige shaded area are 2 standard deviations. About 96% of the time
you would expect the price to be between those boundaries. To be outside
of them, there should be a strong justification, or a reversion back toward the
mean (the 200-day average) would be expected.

Percentage Change: The red dashed vertical
line shows that we essentially already had the Bear we have all been looking
for (a mini-Bear at just down 20%, but it did happen). It was very quick, so
probably did not clear out all of the weak hands. The average Bear takes about
1.5 years to reach its bottom, and then 3+ years to regain the former
peak. This one happened so fast that it probably did not flush out all of
the investors who would run away in a typical deeper Bear building over a
longer period. That probably means there are remaining weak hands to be
concerned about.

Advance/Decline Percentage: The first panel
below the price chart is the Advance/Decline Percentage. AD Percent =
(Advances Less Declines) / Total Issues.

It shows that when the percentage is down to about -90% (a
90% down day) by hitting the bottom blue horizontal line, a bottom is
near or at hand, and that a strong up day is likely to follow. That happened
clearly at the end of December with a 90% up day following the 90% down day.
It also gave clues to the weakening of the most recent rise as it
approached the current downturn.

Percent of Constituents Above Moving Averages:
The second panel below the price chart plots the percentage of the S&P 500
constituents that are above their 200-day average in blue and the percentage
above their 20-day average in dashed red.

Levels below 30% (the lower blue horizontal line) suggest
oversold conditions and the probability of an increase in buying. The
indicators strongly suggested a bottom in late December, and shows the recent
overbought condition (plots above 70%, the upper blue horizontal line) to be
fading, which is consistent with the current dip in the price.

Money Flow Index: The third panel below the
price panel is the Money Flow Index. It measures the amount of money
traded in the security on positive days versus the amount of money flowing
through the security on negative days over a selected period of time (in this
case 14 days). Levels below 20 are considered oversold (and due for an
upward turn), and levels over 80 are considered overbought (and vulnerable to a
downward turn, although overbought conditions may last longer than oversold
conditions). The direction of movement of the indicator is instructive,
and crossing the 50 level might be considered transitioning between positive
and negative condition.

Money Flow was oversold at the December bottom, flirted with
overbought in January, and has been losing steam in February, crossing below 50
yesterday. Overall, it suggests more downward movement for a
while. Basically this confirms the current dip.

MACD: The bottom panel is the popular MACD (Moving Average
Convergence/Divergence oscillator) short-term
indicator. It tracks the positions of short-term moving averages relative to
each other. When the shorter rise above the longer, that is positive, and
when the shorter falls below the longer that is negative. We show
it here as a histogram.

It reached its peak in mid-January, declined steadily and
went negative on February 28, and continues to become more negative – also
indicating more probable downward movement in the S&P 500 in the
short-term.

Chart 6:

Chart 6 is a quarterly chart of the S&P 500 since
its inception in 1957 (241 quarters) along with the 1-quarter rate of change of
the S&P 500 price. The 2018 Q4 decline was 13.97%. That level
or worse noted by the dashed red horizontal line has occurred only 10 times in
241 quarters, which makes it unusual. The vertical blue lines helps show
where in the index price history those strongly negative quarters occurred.
They tended to occur at bottoms, which is an encouraging sign for
intermediate-term potential for the index.

In the long-term price chart visual pattern recognition (“technical analysis”) doesn’t tell you much. In the short-term, it can often be a good guide when deciding when to make the next addition to a position.

Right now the S&P 500 chart suggests holding off on making additional investments in US large-cap stocks until the technical condition becomes Bullish – it is now unclear. It does not suggest reducing US equity exposure, but it does not suggest increasing US equity exposure either.

If you have a new slug of money to invest, or have a cash reserve position to invest, it may be prudent to do that when the technical indicators are more favorable.

Even if technical analysis is basically voodoo, like voodoo it works because people believe in it. If enough investors believe that certain current chart patterns precede and indicate certain near-term future price behavior, then they will act upon that belief, and the belief will be fulfilled – perception is reality.

“Support” and “Resistance” are among the more solid technical indicators. Double and Triple Tops are a commonly accepted indication of a price resistance level. Double and Triple Bottoms are a commonly accepted indication of a price support level.

Prices tend to bounce down from resistance and bounce up from support. When prices move above resistance or below support, they tend to move by a significant amount. That makes support and resistance useful for various kinds of short-term investment decisions, among which is deciding to make that next investment now, or to wait a little while for the price to decide whether to be bounded by the support and resistance, or to break free to continue a trend.

Two other common ways support and resistance are used are in selecting stop-loss exit points, and it selecting strike prices when buying or selling options.

Right now, today, I suggest deferring that next investment into the S&P 500 (or comparable fund) until the price stops playing with the current resistance level (the red dashed line at approximately 2800, formed by the triple top in 2018 shown by red down arrows).

If resistance proves durable (resists multiple attempts by the price to go above it), a material decline in the price of the index would normally be expected, at which point the support level (the dashed green line at approximately 2650, formed by the double bottom in 2018) would then move front and center. If the price does go above the resistance level and remains there for a few days, or moves strongly above the resistance level, a significant price increase would normally be expected. If the price does go below the support level and remains there for a few days, or moves below strongly, a significant price decrease would be expected.

2800 resistance and 2650 support are important lines of demarcation between Bullish and Bearish market views of the index.

The farther apart the failures (“tops”) are and the deeper the drop after, the more meaningful they are as resistance indicators. The two runs at resistance over the last few days are encouraging, because there was not a material decline between them, and the index came right back to try again.

A nice example of support and resistance in play at the bottom of the Bear market after the DotCom crash shows the strong upward price move after the price broke above a resistance level. The tops and bottoms that formed those resistance support levels were spaced apart in months and were at price levels more than 10% apart (both very meaningful). That triple bottom around 800 after a Bear market decline was strongly encouraging, and when the price moved above the resistance around 950, the index moved more than 20% higher over the next 6 months.

Support and resistance can be useful tools to help confirm changes in the direction of a trend.

This article is broad scope ESG, whether by integration with other processes or as a stand-alone process. This article is not in my words, but is a collage of expressions by numerous important sources. Each expression has a link to the source.

This is not about narrow focus, thematic funds such as funds following religious issues, or specific social or environmental issues, for example. It is about asset management utilizing ESG (environmental, social and governance) evaluation in the broadest sense for both inclusionary and exclusionary purposes.

“[in 1970 said] there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud … What does it mean to say that the corporate executive has a ‘social responsibility’ in his capacity as businessman? If this statement is not pure rhetoric, it must mean that he is to act in some way that is not in the interest of his employers …”

“[in 2019 said] The truth is the performance has been abysmal …I think it’s thematic, it’s a fad, it’s sitting around the fireplace singing ‘kumbaya …It makes no sense to me. If you’re an institutional investor, you have to make money for your shareholders, they can take their profits and redistribute their wealth any way they want.”

May 2017, 47,208 CFA Institute surveyed 47,208 portfolio managers and research analysts members online and received 1,588 valid responses … 73% of survey respondents take ESG issues into account in their investment analysis and decisions, with governance being the most common.

Environmental, Social and Governance risks and opportunities have the potential to affect creditworthiness. At S&P Global ratings our analysts work to ensure that we provide essential insights into ESG factors as the relate to the financial markets … we have incorporated relevant environmental, social and governance (ESG) factors, where material in our view, into the qualitative considerations and forecasts for the entities we rate …..

Pre-Financial Risks: Environmental, social and governance (ESG) risks increasingly demand the attention of chief financial officer (CFOs). Companies that aren’t addressing these issues may be caught flat-footed as these pre-financial risk become central to business strategy. …

It is clear from the latest EY research that there is a general, global trend toward increased interest in nonfinancial information on the part of investment professionals. … “One of the key benefits provided by ESG analysis for investors is risk avoidance and measurement.”

We see ESG issues as being fundamental to a company’s long-term performance, requiring serious attention in the boardroom. How a company manages environmental and social issues—and connects these activities with strategy—are important signals to investors of how well the company is run and its long-term financial sustainability…. Given the significant opportunities and risks associated with ESG, companies that excel at identifying and incorporating these issues into their strategy enjoy a competitive advantage in the marketplace and among institutional investors. It is increasingly clear that ESG and ROI are connected…

There’s good reason for investors to put this emphasis on ESG questions. Companies with risk management practices that take into consideration broader industry, regulatory and societal risks are more likely to drive long-term sustainable performance—and shareholder value.

Myth Number 1: Environmental, social, and governance (ESG) programs reduce returns on capital and long-run shareholder value. Reality: Companies committed to ESG are finding competitive advantages in product, labor, and capital markets, and portfolios that have integrated “material” ESG metrics have provided average returns to their investors that are superior to those of conventional portfolios, while exhibiting lower risk. …

Myth Number 5: ESG adds value almost entirely by limiting risks. Reality: Along with lower risk and a lower cost of capital, companies with high ESG scores have also experienced increases in operating efficiency and expansions into new markets …

… Myth Number 6: Consideration of ESG factors might create a conflict with fiduciary duty for some investors. Reality: Many ESG factors have been shown to have positive correlations with corporate financial performance and value, prompting ERISA in 2015 to reverse its earlier instructions to pension funds about the legitimacy of taking account of “non-financial” considerations when investing in companies.

Companies are increasingly scrutinized on how they manage environmental, social and governance (ESG) risks. … ESG risks do affect a company’s bottom line…

… Is there an alpha? How much do [stock investors have] to give up in terms of returns or can we reduce the volatility of returns? …But if you think about who takes a long-term perspective, looking 10 to 20 years out, it’s been the creditors. There has been a surge of interest looking at bonds and loans, and trying to see if better management of environment, social and governance risk factors affects loan spreads, credit spreads, or credit default swap spreads.. … There is data that shows that credit default swap spreads, credit spreads and loan spreads actually do correlate with the ESG risks….. The amount you pay goes up if you’re not very good on ESG. Credit default swap spreads are financial derivatives whose prices are correlated with the likelihood that a bond will default

U.S. Department of Labor issued a bulletin on its prior interpretations related to considerations of ESG factors by ERISA plan fiduciaries. Since then there has been some speculation that perhaps the positions outlined in the Bulletin would act as a speed bump to the increasing focus by investors on ESG matters at public companies.

ERISA requires plan fiduciaries to act solely in the interest of plan participants and beneficiaries for the exclusive purpose of providing benefits to such persons and to discharge their fiduciary duties with the care, skill, prudence and diligence a prudent person would use under similar circumstances.

… Managers of mutual funds and governmental pension funds are not bound by the Bulletin as these funds are not subject to ERISA and therefore not subject to DOL oversight.

… But social policy issues, which might otherwise be considered “collateral issues,” could be treated by plan fiduciaries like any other economic consideration when those issues present material business risk or opportunities that officers and directors need to manage as part of their companies’ business plans.

… plan fiduciaries cannot focus on ESG factors solely to benefit the greater societal good, or assume that ESG factors that promote positive market trends are by their nature economically relevant. However, ESG factors or tools, metrics or analyses can be evaluated if fiduciaries believe they would impact an investment’s risk or return.

EU law requires large companies to disclose certain information on the way they operate and manage social and environmental challenges. … Companies are required to include non-financial statements in their annual reports from 2018 onwards. … This covers approximately 6,000 large companies and groups across the EU

Pension funds and investment managers in China are now encouraged by the government to look closely at ESG risks and opportunities in their investment process. … these themes are also part of the newly revised Code of Corporate Governance for Listed Companies (2018) from the China Securities Regulatory Commission (CSRC);

“Asset managers have to adjust their conventional business model. Investors will be more focused on the long-term investment theme, as AI will take over the short-term trading…In other words, investors will shift their focus to the long-term sustainability of their portfolio, and more focus on their investment themes like ESG …”

… The world’s largest pension fund takes a strong stance. Japan’s Government Pension Investment Fund with US$1.4 tn of assets under management now requires external asset managers to incorporate ESG. GPIF’s size and focus on ESG integration is having a material impact on investor stewardship and engagement with ESG, including for passive asset managers …

Nobel prize-winning economist Milton Friedman argued that “there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud”. His views influenced generations of academics and corporate executives.

Friedman stated in his 1970 article for the New York Times: “What does it mean to say that the corporate executive has a ‘social responsibility’ in his capacity as businessman? If this statement is not pure rhetoric, it must mean that he is to act in some way that is not in the interest of his employers.”

(surveyed 500 CIOs and buy-side analysts managing $4.5 Trillion assets) … Most institutional investors demand public companies address environmental, social and governance issues to be regarded as trustworthy … It’s plain to see that ESG is a major criteria for investors … this is a meaningful shit within the investment community in terms of critical mass being reached …

According to a survey of 475 institutional investors … more than half of institutions that have adopted environmental, social and governance (ESG) investing cite a lack of clarity over ESG terminology.

… we analyzed (2005 to 2017), S&P 500 stocks with high Environmental scores based on the three datasets we analyzed would have outperformed their low ranked counterparts by as much as 3ppt per year. An investor who only bought stocks with above-average Thomson Reuters’ Environmental and Social scores five years ahead of a company’s bankruptcy would have avoided 90+% of the bankruptcies that occurred in the S&P 500 since 2005. And ESG is a better signal of earnings risk than any other metric we have found. ..

Compared to the investment universe as a whole, more than one quarter of the world’s professionally managed assets— roughly $22.9 trillion—now have some sort of sustainable investing mandate, with about $8.7 trillion of that in the United States, $12 trillion in Europe and the rest shared by other regions.

consumer trends point toward greater returns for sustainable companies. Nearly nine in 10 (87%) U.S. consumers say they will purchase a product because of a company’s stance on an issue they care about, and 78% say they want companies to address important social issues…. Among millennials, this is even more pronounced. Our 2017 survey of individual investors found that millennials are more than twice as likely as other generations to purchase products from companies they view as sustainable.

… fully 78% of respondents listed risk management as an important factor driving their adoption of sustainable investing.

a majority (57%) continued to believe that investing sustainably requires a financial tradeoff.8 While this perception may have grown out of early views of ESG as a negative screen that narrows the investment universe, it appears that large institutional asset owners may be replacing this view with a more sophisticated recognition that ESG factors provide unique insights into long-term risks and opportunities that might not be captured by traditional financial factors. The belief in a trade-off appears to be fading

ESG Integration ESG integration—proactively considering ESG criteria alongside financial analysis—emerged as the most common approach …More than half are required to do so by their Investment Policy Statement

Strengthening risk management. Institutional investors increasingly observe that risks related to ESG issues can have a measurable effect on a company’s market value, as well as its reputation. Companies have seen their revenues and profits decline, for instance, after worker safety incidents, waste or pollution spills, weather-related supply-chain disruptions, and other ESG-related incidents have come to light. ESG issues have harmed some brands, which can account for much of a company’s market value. Investors have also raised questions about whether companies are positioned to succeed in the face of risks stemming from long-term trends such as climate change and water scarcity.

… the investor community will fully integrate environmental, social and governance (ESG) considerations into its investing approach.

There is no question that sustainability is moving up on the corporate agenda. When Bain & Company surveyed 297 global companies, 81% said sustainability is more important to their business today than it was five years ago, and 85% believe that it will be even more important in five years. The evidence is everywhere. Sustainability is now incorporated into two-thirds of companies’ core missions …

…For decades, most companies have oriented their strategies toward maximizing total shareholder return (TSR). This focus, the thinking has been, creates high-performing companies that produce the goods and services society needs and that power economic growth around the world. According to this view, explicit efforts to address societal challenges, including those created by corporate activity, are best left to government and NGOs.

Now, however, corporate leaders are rethinking the role of business in society. Several trends are behind the shift. First, stakeholders, including employees, customers, and governments, are pressuring companies to play a more prominent role in addressing critical challenges such as economic inclusion and climate change. …

Our analysis indicates that, in general, increasing exposure to ESG rarely underperforms the market, and often outperforms the market,…

… to what extent are ESG scores different from the factors found in commercial fundamental factor risk models, such as value, size, industries and countries? … To the extent that ESG scores overlap with traditional factors, then ESG can be interpreted as beta (“smart beta” to the marketers); to the extent these scores do not overlap with traditional factors, then ESG can be interpreted as residual, idiosyncratic or company specific (“alpha” to the quants).

Addition of ESG may not always boost performance, but it also appears unlikely to be a significant drag on performance. And there have been periods of time across multiple regions in which ESG has improved performance.

Finally, we note that there is no standard, accepted methodology for combining separate E, S, and G scores into a composite ESG score. It is possible, indeed, likely, that ESG scores from different vendors will exhibit different performance characteristics.

Two perennial questions have accompanied the deluge of money. The first is whether the approach comes with special costs: ie, is there a virtue discount? Second is the question of what should be measured. Neither is easy to answer

…One attempt to answer the first looked at the converse: were returns higher for shares that would not qualify for inclusion in these efforts: in other words, is there a vice premium? … A paper published in 2009 called “The Price of Sin”, by Harrison Hong and Marcin Kacperczyk, two academic economists, concluded that there were indeed unusual returns in firms that sold tobacco, alcohol and gambling. …

However, a second paper published this year (“Sin Stocks Revisited”, by David Blitz of Robeco Asset Management and Frank Fabozzi of EDHEC Business School) contests these results. It argues that added risk factors such as low reinvestment rates mean that there is no evidence that sin stocks provide a premium for reputation risk. Robert Whitelaw, a professor at New York University’s Stern School of Business, says that the conflicting analyses reflect the broader results of more complex efforts aimed at tracking results from (“virtuous”) companies that would qualify for these funds. Results are mixed.

…Warren Buffett has pledged to give his fortune away but has said social-impact agendas in business force executives to pursue a confusing array of goals. Free-market guru Milton Friedman decried them in a 1970 essay that’s still debated today. … Advocates of sustainable agendas dispute the premise that there must be a cost. They cite studies in which companies with such goals financially outperformed companies without them, though researchers face a challenge proving it was the strategy that created better results… In any case, better information is needed to determine how companies perform on non-financial goals.

…ESG factors cover a wide spectrum of issues that traditionally are not part of financial analysis, yet may have financial relevance. … Institutional investors were initially reluctant to embrace the concept, arguing that their fiduciary duty was limited to the maximization of shareholder values irrespective of environmental or social impacts, or broader governance issues such as corruption. … But as evidence has grown that ESG issues have financial implications, the tide has shifted. … The idea that investors who integrate corporate environmental, social and governance risks can improve returns is now rapidly spreading across capital markets on all continents. …Cynics may argue that responsible investing is just a fad. But a closer look at the forces that have driven the movement over the past 15 years suggests otherwise. … For investors, ESG data is increasingly important to identify those companies that are well positioned for the future and to avoid those which are likely to underperform or fail. …

…Today there’s a growing body of evidence showing that companies that put social responsibility first can also finish first in the market. … When companies make decisions that show respect for the environment, their communities, and their employees, there’s less likelihood that they’ll be hit with the kinds of fines, public backlash, and boardroom turmoil that can slam their share prices. … There’s also a strong correlation between ESG-minded management and longer-term strategic thinking—another factor that increasingly distinguishes top companies from laggards.

According to ESG advocates, companies that stand out in these areas will be more successful over the long haul than companies that don’t. … The knock on all social investing strategies has been that … you sacrifice some return. Morningstar analyst David Kathman says maybe not. “There is no evidence that shows ESG or socially responsible investing helps or hurts performance …Over the long term, it probably evens out.”

Lower risk of severe incidents … Over the past 10 years, higher ESG-rated companies showed a lower frequency of idiosyncratic risk incidents, suggesting that high ESG-rated companies were better at mitigating serious business risks.

In 2018, most major asset managers are committed to incorporating ESG criteria and risk factors in their investment … As increasing numbers of investors seek to integrate sustainability and ESG risk factors in their investment strategies, it is becoming clear that there is a lack of clarity with regard to the various approaches adopted as well as a sense of frustration that there is no general consensus about what is financially material in this context. … Investors are generally asking, “Which factors and underlying data should we consider,what are the key sources of ESG risks and subsequent value creation for a particular industry or company, and which long-term risk patterns are likely to have a negative impact on these value drivers?” … ESG performance can be directly related to companies’ revenues and costs … allows investors to hedge potential portfolio drawdowns, i.e. a certain minimum frequency of severe risk incidents related to a particular ESG issue in a specific sector is XX % likely to have a negative impact of at least YY bps and increase beta of a stock by ZZ %.

… companies who invest in their employees, treat their customers well, work to create quality products, are sustainable, care about their communities, create jobs, and have ethical benefit employees, consumers, communities, and the environment, [but do they] benefit shareholders and the companies themselves … do JUST stocks outperform over the long-term? … Since its November 30, 2016 inception through September 2018, the Index has cumulatively outperformed the Russell 1000 … [but] does the Index provide a positive alpha, or unexplained investment residual, after controlling for the five Fama-French factors? After running a regression of the daily [index] excess return over the Russell 1000 on the five Fama-French factors from December 1st, 2016 through August 31, 2018 … we’d answer yes, it does.

One of the most frequently asked questions is whether an investor can “do good and do well” when screening portfolio. … A simple yes-or-no answer is no reasonable because there are a variety of potential inclusionary and exclusionary screening preferences … There is currently no industry consensus on this answer and commonly cited meta study has shown mixed results …

ESG Investing (environmental, social, and corporate governance) used to carry the stigma that investors needed to make certain concessions in order to participate. But research shows you don’t necessarily have to sacrifice performance or price when choosing investments that make a positive impact.

“Evidence shows that companies that have better ESG management tend to outperform in the long term, and they’re more resilient during times of economic downturn,” says Christina Zimmerman, manager of ESG research at Wellington Management. “We do this to get better risk-adjusted returns.”

Is ESG such a factor? …With some caveats, we feel that ESG can indeed be utilized as a factor in portfolio construction. …most academic studies on the topic suggest that at worst the relationship between ESG and corporate financial performance is at least non-negative.

What makes ESG unique is the degree of disagreement regarding what should go into an ESG score and how those metrics should be weighted. Further, there are no simple ESG definitions, no book-to-price equivalent of ESG that can be applied universally. … When building a quantitative, factor-based portfolio, we feel that these ESG ratings are best used when integrated with certain other financial factors.

Specifically , we find that ESG and quality make a particularly potent factor combination as each factor captures a different dimension of sustainability — non-financial and financial. … he jury is still out on whether ESG is a compensated risk factor.

We find ESG can be implemented across most asset classes without giving up risk-adjusted returns. … ESG-friendly portfolios could underperform in ‘risk-on’ periods – but be more resilient in downturns. … Early evidence suggests that focusing on ESG may pay the greatest dividends in emerging markets (EMS).

… while accidents and impropriety can happen at any time, the ESG themes manifest themselves over longer time horizons as opposed to more traditional financial metrics whose consequences can impact more quickly. … ESG information tends to be the most effective at identifying poor ESG firms that are more likely to underperform as opposed to predicting future outperformers.

Since the Forum for Sustainable and Responsible Investment (US SIF) began researching SRI in 1995, the assets in these types of investments have grown from $639 billion to nearly $12 trillion. That’s an 18-fold increase and a compound annual growth rate of 13.6%.1

Additional data from Morningstar shows that, on average, SRI mutual funds have slightly outperformed their non-SRI counterparts in the short, medium and long terms …

… we show that poor ESG exposures predict increased future statistical risks. While the effect is modest in magnitude, it is consistent with ESG exposures conveying some information about risk that is not captured by traditional statistical risk models. … ESG exposure tends to predict increases in statistical risks (i.e., risks captured by traditional risk models) in the future. Controlling for current risk characteristics of a given stock, that stock’s ESG score helps forecast future statistical risks up to five years later. In other words, ESG exposures may convey information about future risks that are not captured by statistical risk models….

…the total volatility of the average stock in the first quintile (worst ESG) is 35%, versus 30% for the average stock in the fifth quintile (best ESG). …

Environmental and social shareholder proposals represented 41% of all documented shareholder proposals in 2017, up from 33% in 2016, including contributions from BlackRock, Vanguard, Fidelity, Capital Group and others …

…Social media platforms such as Facebook, Twitter and Glassdoor have handed society a powerful megaphone. The speed and scale at which news now spreads expose companies to new reputational risks and in effect holds them more accountable to internal and external ESG issues. …

… according to surveys from Deloitte and Cone Communications (part of Omnicom Group), responsible business practices have a profound effect on Millennial’s views of business and ultimately their employment decisions. …

T. Rowe Price CIO Rob Sharps: “Environmental, social and governance factors are important in any comprehensive investment research process.”

Putnam Investments CIO Aaron Cooper: “There is a growing realization in the marketplace that companies engaged in sustainability often show enhanced fundamental and financial performance”

GMO Founder and CIO Jeremy Grantham: “Interest in ESG isn’t necessarily because of the rush of blood to being good. It could be just good business. … There’s quite a lot of work that suggests that people who are early movers on good behavior are demonstrating that they are simply thinking more about the future, how it will look, how it will play out over 10 or 15 years.”

…when investors seek value these days, they often end up with securities that represent values – an alignment with increasingly popular environmental, social and governance (ESG) principles. …we identified positive ESG tilts as consistent with many fundamental investment processes.

… We had heard that ESG might be value-detracting, so we expected to see a negative tilt in active portfolios. Instead, we discovered that many active managers, who are seeking to add value over their benchmarks, actually have positive ESG tilts. In a number of regions, more active managers have positive ESG tilts than negative ESG tilts.

This finding suggests that positive ESG tilts are consistent with managers’ intent to add long-term value through security selection. While the manager may or may not be purposefully screening for ESG factors, their investment criteria are identifying securities that in fact result in significant ESG tilts. Think of this as latent ESG.

…we recommend using ESG in conjunction with fundamental attributes like valuation, growth and quality. In this report, we analysed results from combining ESG with other fundamental factors, and found that adding ESG would have consistently outperformed fundamental strategies with less risk. For example, dividend investors who had added ESG to their process would have increased their average returns by ~200bps per annum….